December 10, 2007

Economist's View - 5 new articles

CME Group Fed Watch: Based upon the December 10 market close, the 30-Day Federal Funds futures contract for the December 2007 expiration is currently pricing in a 100 percent probability that the FOMC will decrease the target rate by at least 25 basis points from 4-1/2 percent to 4-1/4 percent at tomorrow's FOMC meeting. In addition, the 30-Day Federal Funds futures contract is pricing in a 42 percent probability of a further 25-basis point decreasein the target rate to 4 percent (versus a 58 percent probability of just a 25-basis point rate decrease).

Justin Fox, in response to my criticism of his statement that ""Some tax cuts do raise revenues", says:

Do tax cuts ever raise revenues?, by Justin Fox: Mark "Economist's View" Thoma was appalled by my statement in this post that, "Some tax cuts do raise revenues, of course." So much so that he took back a bunch of nice things he'd just said about my column on Arthur Laffer. ...

I'm certainly not going to say that no tax rate cuts have ever raised revenues. Would Mark Thoma say that?

Yes I would, see below. Continuing:

Just two off the top of my head: The 1964 Kennedy reduction of the top marginal income tax rate from 91% to 70% (it was enacted after JFK's assassination, but it was his bill), the 1981 Reagan reduction of the top marginal rate from 70% to 50%. I'm not at all an expert on this, but I don't think it's too controversial among economists to assert that those particular changes (but not the rest of the of Kennedy and Reagan tax legislation) were a break-even or better for the Treasury. (Brad DeLong on the 1980s tax cuts: "As I read the evidence ... reducing the top tax rate from 70% to 50% is probably a revenue gainer and surely not much of a loser. From 50% to 28% is, I think, very different: a big revenue loser.") ...

He's right, it's not controversial, but the lack of controversy is in the other direction, and it's too bad Brad has confused the issue. Let's look at what other economists have said. Quoting Robert J. Gordon's textbook, Macroeconomics, pg. 394:

The fact that the United States entered into an era of persistent deficits after the Reagan tax cuts suggests that it moved from a point like C to B in the 1980s, not from D to C.

He is talking about a graph of the Laffer curve and moving from C to B is a fall in revenues. Likewise, William Baumol and Alan Blinder's text, Macroeconomics, says (pgs. 195-197):

The large Reagan tax cuts in the early 1980s ballooned the budget deficit ... Thus supply-side tax-cuts are bound to raise the government budget deficit. This problem proved to be the Achilles heel of supply-side economics in the United States in the 1980s. It left behind a legacy of budget deficits that took 15 years to overcome.

So, the Reagan tax cuts do not provide us with an example of tax cuts paying for themselves, not at all. There's no controversy about whether deficits increased after the Reagan tax cuts - they did - so the Reagan tax cuts were not self-financing. It's disappointing to see that some people think they were after all the debunking of this myth that has occurred.

It was mainly the suggestion about the Reagan tax cuts that brought the response, but let's deal with the Kennedy tax cuts as well. Did they pay for themselves? Unlikely. Rather than running down a bunch of references, here's the explanation for the confusion. It's important to remember that the debt from the Vietnam war was, to a large extent, monetized (so the debt that was created was hidden by monetary policy). Thus, throughout this period there was stimulus to the economy from debt monetization, and when evaluating the tax cuts it's important to take this effect out (i.e. the effect that monetary policy had on stimulating output as well as the reduction in debt from the debt monetization). When you do, the evidence that the tax cut paid for itself just isn't there.

So, to answer Justin's question once again, yes, I would and do say that there's no evidence that tax cuts have ever paid for themselves. [I realize that there is an attempt by Brad and Justin to isolate particular features of the tax changes, e.g. to just look at the change for the top group in isolation and analyze those changes by themselves, and I suppose with a narrow enough focus we could find somebody who paid more taxes after the change, perhaps even a group who did, but to me that just confuses the issue - overall these tax cuts did not pay for themselves, and even the statement that they did for small subgroups at the very top is debatable and subject to interpretation].

As the staff economist for Representative Jack Kemp, a Republican of New York, I helped devise the tax plan he co-sponsored with Senator William Roth, a Delaware Republican. Kemp-Roth was intended to bring down the top statutory federal income tax rate to 50 percent from 70 percent and the bottom rate to 10 percent from 14 percent. We modeled this proposal on the Kennedy-Johnson tax cut of 1964, which lowered the top rate to 70 percent from 91 percent and the bottom rate to 14 percent from 20 percent.

We believed that our tax plan would stimulate the economy to such a degree that the federal government would not lose $1 of revenue for every $1 of tax cut. Studies of the 1964 tax cut showed that about a third of it was recouped, and we expected similar results. Thus, contrary to common belief, neither Jack Kemp nor William Roth nor Ronald Reagan ever said that there would be no revenue loss associated with an across-the-board cut in tax rates. We just thought it wouldn't lose as much revenue as predicted by the standard revenue forecasting models...

I think that's overly optimistic (recovering a third), but even that is a far cry from self-financing.

Fernanda Llussá and José A. Tavares say most of what you heard about terrorism is probably wrong. This is a summary of economic research on the causes and consequences of terrorism:

Do we know enough about terrorism?, by Fernanda Llussá and José A. Tavares, Vox EU: Probably not. Think of terrorists as irrational misanthropes with little education and low income. Think of terrorist attacks as causing major economic damage. Think of fear of terrorism as perfectly rational and well understood. If you think like this, you may gain some comfort from the fact that many people think like you. But you (and they) are wrong. Probably, completely wrong, according to the empirical and theoretical research on the economics of terrorism available. The fact that popular beliefs about terrorism have received little influence from research in the topic – and, to some extent, also the reverse – coupled with the urgency of knowing more, suggests the importance of further research. In other words, given its relevance, we know too little about the causes and consequences of terrorism.

Understanding terrorism has gained actuality after the September 11 attacks in New York. The number of victims – and the direct material damages - is by far the largest in the history of terrorism, even if assessed in relative terms, compared to the US population and output. Despite huge fluctuations in intensity over time, the history of terrorism shows it has evolved from ideologically-based to religious-based, and becoming more lethal over time. Its objectives are to disrupt the economy, destabilize the polity and influence a wide general "audience", well beyond the immediate targets.[1] Enders and Sandler´s (2002) define terrorism as "the premeditated use or threat of use of extra-normal violence or brutality by sub-national groups to obtain a political, religious, or ideological objective through intimidation of a huge audience, usually not directly involved with the policymaking that the terrorists seek to influence".[2]

In a recent article, we attempt to portray, in broad brush strokes, the scope and depth of the economics of terrorism[3] and a forthcoming chapter in Terrorism, Economic Development and Political Openness, to be published by Cambridge University Press,[4] presents the existing literature on the topic, highlighting what are the issues that, in our opinion, deserve more attention in the future. The literature on the economics of terrorism is organized along seven self-explanatory topic areas:

The Measurement of Terrorist Activity

The Nature of Terrorists

The Utility Cost of Terrorism

Impact of Terrorism on Aggregate Output

Terrorism and Specific Sectors of Activity

Terrorism and Economic Policy

Counter-Terrorism

It is obvious that some of the areas above lend themselves more naturally to a micro-based approach, while others are best dealt with by models and data that portray the aggregate economy. While work on the nature of terrorists and the utility cost of terrorism is mostly microeconomic and theoretical, work on the impact of terrorism on aggregate and sectoral activity and on economic policy has been mostly empirical and macroeconomic in nature. Topics such as the measurement of terrorist activity and issues of counter-terrorism have drawn widely from both micro and macro approaches. A simple, and obviously subjective, breakdown of the existing research is illuminating.[5]

In the table at the end of this column, which is not in the original paper, we divide the articles surveyed into four little boxes according to the main method (empirical or theoretical) and approach (micro or macroeconomic). As can be verified, almost three-quarters of the papers use a macroeconomic approach, while the literature shows a balance between theoretical and empirical approaches, with the latter covering just a little more than half of the papers. The crossing of the two category axes reveals an interesting fact: while micro papers are mostly theoretical, macro papers are mostly empirical. This may be driven by the fact that individual data on terrorists and terrorism, as well on attitudes towards terror, is scarce, while aggregate datasets of the incidence of terrorism are now amply used by researchers.

Our examination of the economics literature on terrorism shows that most of the studies concentrate on the consequences of terrorist attacks at the aggregate level and in specific sectors of activity. This important literature is empirical in nature, and uses a limited number of datasets that are available. There are notable examples of papers examining the causes or consequences of terrorism in the context of theoretical models of individual, group or aggregate economic behaviour, but the analysis of individual actors is constrained by data limitations. Another strand in the literature is policy oriented and, though presenting neither an explicit theoretical model nor an empirical exercise, does in some cases raise useful insights.

Our reading of the literature is that there are additional issues, methods, and data, which can yield important new insights into the causes and consequences of terrorism, at a time they are much in demand. On the measurement side, existing datasets need to be improved to cover the type and nature of terrorist attacks, according to several classifications. Econometric and statistical techniques that deal with censored data and outliers need to be more actively employed, in order to assess the underlying level of terrorist activity. This is key, since terrorist attacks are extremely volatile, and much important activity does not lead immediately or directly to actual attacks. Terrorists, as evidenced by much of the existing research, are rational actors that organize and make decisions in pursuit of given objectives. They substitute between means, targets and over time, in response to the costs imposed on them by counter-terrorist measures. More work is needed on the "industrial organization of terrorism", since most terrorists act in groups, as well as on the "psychological incentives" of individual terrorists. Needless to say, progress on the latter depends crucially on inter-disciplinary work, ranging from psychology and political science to media studies. The "utility cost" of terrorism, recognized to be well above a simple "rational", expected value estimate, can and should be assessed directly through careful individual surveys that use contingent valuation techniques of the sort already in use in public and environmental economics. The economic cost of terrorism is almost consensually estimated to be small, even in the short-run, but there should be an effort to relate the cost of terrorism to the literature on volatility and growth. Evidence on the differential sectoral impact of terrorism suggests that it is important to identify which characteristics of terror attacks affect which components of output, be it investment – private and public – or consumption. A related line of research is to use the very wide data on tourist movements, including origin and destination, with information on cost and length of stay, to evaluate more finely the impact on and the substitution effect between tourist destinations that are targeted by terrorists. The research on counter-terrorism can focus on the actual or alleged asymmetries between the terrorists and the government actors, in terms of information and cost of action. A final but most important unexploited avenue for research is the detailed analysis of how the specifics of the media coverage of terrorism attacks may affect the dynamics of terrorism.

If we accept as given the findings of the existing research, the perceived utility cost of terrorism is enormous in comparison with its economic and political costs. This suggests that knowing more about the nature of the "beast" – an adjective, as we have seen above, that should be used here in metaphorical terms - and how to counter it, are the main tasks ahead in terms of research. If we go back to the seven topics along which we organized the economics of terrorism, the nature of terrorism and the effectiveness of counter-terrorist measures are two areas where micro and macro approaches have mixed very well so far, despite a scarcity of empirical work. We need to add solid new databases to that "conversation", and bring together researchers from other scientific fields to address head on the important questions at hand.

Unfortunately, and also for the worst of reasons, terrorism will be high on the political agenda for years to come. It should also remain high in the research agenda, to inform policy that aims at countering its effects. Given the nature of the actors, the interactions between them and the high stakes involved, the role of economics in that research effort is likely to remain central.

1 The origins of the term terrorism go back to the state use of violence during the French Revolution, in the 18th century, and refer precisely to its wide, "irrational" impact on an "audience".
2 See Enders and Sandler (2002), "Patterns of Transnational Terrorism, 1970-1999: Alternative Time-Series Estimates", International Studies Quarterly.
3 "Economics and Terrorism: What We Know, What We Should Know and the Data We Need", published as CEPR Working Paper DP6509
4 See the book page at http://www.cambridge.org/us/catalogue/catalogue.asp?isbn=0521887585
5 In this article we have decided to exclude monographs, many of which have derived from or find further reflection in academic papers. We also excluded survey articles.

But Mr. Paulson's actions reflect the priorities of the administration he serves. And that, ultimately, is what's wrong with the mortgage relief plan he unveiled last week.

The plan is, as a Times editorial put it yesterday, "too little, too late and too voluntary." But from the administration's point of view these failings aren't bugs, they're features.

In fact, there's a growing consensus among financial observers that the Paulson plan isn't mainly intended to achieve real results. The point is, instead, to create the appearance of action, thereby undercutting political support for actual attempts to help families in trouble.

In particular, the Paulson plan is probably an attempt to take the wind out of Barney Frank's sails. Mr. Frank ... sponsored legislation that would give judges in bankruptcy cases the ability to rewrite mortgage loan terms. But "Bankers Hope Bush Subprime Plan Will Scuttle House Bill," as a headline in CongressDaily put it. ...

There are, in fact, three distinct concerns associated with the rising tide of foreclosures...

One is financial stability: as banks and other institutions take huge losses ..., the financial system as a whole is getting wobbly.

Another is human suffering: hundreds of thousands, and probably millions, of American families will lose their homes.

Finally, there's injustice: the subprime boom involved predatory lending ... on an epic scale. The Wall Street Journal found that more than 55 percent of subprime loans made at the height of the housing bubble "went to people with credit scores high enough to often qualify for conventional loans with far better terms."

And in a declining housing market, these victims are stuck, unable to refinance.

So there are three problems. But Mr. Paulson's plan ... is entirely focused on reducing investor losses. Any minor relief it might provide to troubled borrowers is clearly incidental. And it is does nothing for the victims of predatory lending. ...

This is supposed to help investors, because foreclosing on a house is expensive... "Foreclosure is to no one's benefit," said Mr. Paulson... "I've heard estimates that mortgage investors lose 40 to 50 percent on their investment if it goes into foreclosure."

But won't the borrowers gain, too? Not if the planners can help it. Relief is restricted to borrowers ... that in many, perhaps most, cases ... would be nearly as well off in financial terms if they simply walked away.

And what about people with good credit who were misled into bad mortgage deals, who should have been steered to loans with better terms? They get nothing: the Paulson plan specifically excludes borrowers with good credit scores. In fact, the plan actually provides an incentive for some people to miss debt payments, because that would make them look like bad credit risks and eligible for relief.

Now, Mr. Paulson's attempt to help investors, while doing little or nothing for distressed and defrauded borrowers, might make sense if his plan would reduce investor losses enough to seriously improve the overall financial situation. But ... the plan is unlikely to reduce overall mortgage-related losses by more than a few percent, at most — not enough to make any real difference...

Still, you might say that the Paulson plan is better than nothing. But the relevant alternative isn't nothing; it's a plan that — like Barney Frank's proposal — would actually help working families. And that's what the administration is trying to avoid.